Three Myths About Income Tax in Retirement

Active retirement old people and seniors free time group of four elderly men having fun and playing cards game at park. Waist up

 

 

Do you still have to pay income tax after your retire?  The short answer is: YES!

 

I’m not sure why, but there seems to be a myth floating around about seniors not paying taxes. I’ve always had to deal with seniors in trouble for not filing tax returns when they needed to, or not paying tax on their IRAs, but lately I’ve been hearing the age myth. Three times in the past three weeks I’ve heard real people say the following things:

 

“Now that I’m 65 I don’t have to pay self employment taxes on my 1099 income.”

“What do you mean I need to be concerned about required minimum distributions, I won’t have to pay tax after I’m 70 anyway?

 “I won’t need you to do my taxes anymore now that I’ve turned 80. There’s no taxes after 80.”

 

The bad news is: those statements are all false!   The IRS doesn’t really care how old you are.  They still want your money.  So how do some of these myths get started in the first place?   Well, some states don’t tax your retirement income.  So if you live in one of those states, it’s easy to assume that the IRS doesn’t tax it either, but the IRS does tax retirement income, and they don’t care how old you are.

 

Myth 1, not paying Social Security tax after age 65:  Once you start receiving Social Security benefits, it’s easy to assume that you won’t be paying into Social Security anymore.  But–you do.  Actually, if you’re still working after your full retirement age you might even increase your Social Security benefits.  It all depends upon your circumstances, but you’ll want to check with Social Security to make sure that you’re being credited for your Social Security contributions.

 

Myth 2, no taxes after age 70:  After age 70 1/2 you are required to start taking money out of your IRAs.  It’s called Required Minimum Distributions (RMDs)- and that money is taxed.  The quick and dirty calculation to figure your first year RMD is to take the total dollar amount of the money you have in all of your IRAs and divide by 28.  Now, this is a quick and dirty calculation.  Different ages, and different situations can get you different results.   If you want to compute an RMD for a different age, try the Kiplinger calculator:  http://www.kiplinger.com/tool/retirement/T032-S000-minimum-ira-distribution-calculator-what-is-my-min/index.php

 

For many people over 70, you don’t stop paying taxes, you actually pay more in taxes.  If you don’t know about the RMDs and you need to be taking them, there can also be some pretty hefty penalties.

 

Myth 3, not paying taxes  after age 80:   I don’t know where that came from.   (Actually, I heard it from my mother-in-law who heard it at the senior center.  But I don’t know where it started.)   Many seniors don’t pay tax because their income is low enough not to pay, and they aren’t required to file.  But they’re not paying tax because of their low income, not because of their age.

 

And even if you’re not required to file, I still recommend submitting a return anyway to prevent identity theft.

Is My Social Security Income Taxable?

Do I have to pay tax on Social Security?

Photo by Jan Roberg.

People often ask me if their Social Security income is taxable.  No, sorry, I just lied.  When I finish preparing  a tax return for someone on Social Security I’ll often hear, “What do you mean my Social Security is taxable? ”  People who say that are usually angry when they say it too.  But, for many people, Social Security is taxable.

So how do you tell if your Social Security is going to be taxed?  Here’s the quick and dirty way to figure it out.  First, take half of all of the Social Security income you get and add that to all of the other income you get.  If you’re single and the amount is over $25,000 you’ll start getting hit with tax.  If you’re married filing jointly—then you’ll start getting hit at $32,000.  If you’re married-filing separately and don’t live apart—then it’s all taxable.

So this can totally mess up your tax rates.  For example—let’s say you ‘re currently in the 15% tax bracket and you haven’t crossed into “Taxable Social Security Land” yet, but you’re right on the border.  You want to take a really nice vacation and it’s going to cost you $10,000.  How much money do you need to take out of your IRA to go on vacation and pay the income tax?

Well, you know you need 15% more for the tax so let’s say you take out $12,000.

$12,000 X 15% = 1800

That means that you’ll have $10,200 for your vacation, right?  (12,000 IRA – 1,800 income tax = 10,200 vacation money)

Looks good, except it’s wrong.  See, if you’re on that border, then half of the $12,000 is going to go into the taxable Social Security pile.  So instead of paying 15% on $12,000 you’re paying 15% on $18,000; that’s another $900 in taxes.  ($18,000 X 15% = $2,700    and    $2,700 – $1,800 = $900) 

Now you don’t have enough money to pay for your vacation.  You’ll need to be taking more out of your IRA and then even more of your Social Security will be taxed.

Because taking that distribution makes your Social Security Taxable—your real tax rate is 22.5% instead of 15%.

$2,700 tax divided by $12,000 distribution = 22.5% tax rate

For lots of people, there really isn’t much you can do.   If your income is high enough, you’re stuck with your Social Security being taxed and there’s no way out.   But for some folks—you can plan ahead to avoid this bumped up tax—or at least try to reduce it.  You’ve got to know about the tax though if you’re going to plan ahead for it.  If you want help figuring out if your Social Security is taxable, give us a call.

How Much Can I Contribute to My 401(k)?

Piggy Bank

Photo by Danielle Elder on Flickr.com

Good question! Starting in 2012, you can put up to $17,000 away for retirement in a 401(k) plan. This figure also holds for people who have 403(b) plans and any of the 457 plans as well. If you happen to be over 50, you’re allowed what’s called a catch-up contribution so you can add an additional $5,500, making your total 401(k) contribution $22,500 for 2012.

Remember, money that goes into a 401(k) is tax-deferred so although you’re not paying tax on the money now, you will pay tax on it when you do withdraw it for retirement. If you take the money out of the plan before you reach the age of 59 ½, there’s a 10% additional penalty on top of the regular tax that you’ll pay. As much as I think 401(k) plans are a great deal, if you think that you’re going to need the money before you retire, you might want to re-think your contribution.

A good rule of thumb is that a person should be contributing 10% of his or her income into a retirement program. If you can afford 15%, that’s better, but 10% for sure.

Some companies have what’s called a Roth 401(k)—it basically works like a Roth IRA: you pay your income tax on your retirement plan contributions now, but when you take the money out later it’s tax free. Roth 401(k) plans have the same limits as regular 401(k) plans. If you have access to one of these plans you should seriously consider using it. For anyone who is in a 15% or lower tax bracket, choosing the Roth should be a no-brainer. If you’re in the 25% tax bracket and under 40, I’d still go with the Roth. After that, I’d start doing some serious considerations of what my future plans were, how early I’d want to retire, and other factors.

If your income is below $58,000, you can make fully deductible IRA contributions in addition to your 401(k) contributions (For married couples it’s $92,000.) This gives you some wiggle room. If you’re not comfortable committing to your 401(k) contribution rate, you can make up the rest with an IRA if you’ve got the funds at the end of the year.

If you haven’t started saving for retirement yet, this is the time to start.

IRAs for Dummies

Writer

 

Okay first and foremost, you’re not a dummy!  But I wanted to make a simple post with simple explanations about IRAs.  This isn’t the be all end all of IRA stuff.  But hopefully it will give you a little clue about them.

A traditional IRA lets you put money away for retirement and you can get a tax deduction for the money that you put into the IRA.  For example:  if you’re in the 25% tax bracket and you put $1,000 into an IRA then you will save $250 in taxes for the year you put the money in.  (The tricky part is that there are limits as to how much is deductible if you or your spouse have a retirement plan at work.  There are also complications if you’re using the married filing separately status.  I’m not covering that here.  If this sounds like you, give me a call and I can help you figure it out.)
A Roth IRA lets you put money away for retirement but you don’t get a tax deduction for the money you put in.  $1,000 into a Roth IRA gives you no tax savings.  (There are income limits for contributing to a Roth, the phase out starts at $167,000.  If you’re under that income level, you’re fine.)
Generally, the most you can contribute to an IRA in a year is $5,500.  If you’re married, you can contribute $5,500 for you and $5,500 for your spouse, even if your spouse doesn’t work.  You can’t put more money into an IRA than you earned (so if you only made $3,000 that’s going to be your maximum contribution.)   If  you’re over 50 years old, you can contribute up to $6,500 to your IRA.
Remember, the $5,500 is a maximum.  It’s fine to contribute less.  Most accounts are going to want at least a $1,000 to open, but you don’t have to have $5,500 to put into an IRA. Its not an all or nothing kind of investment.
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When you take money out of your traditional IRA, the money you take out is taxable.  So, once again if you’re in the 25% tax bracket and you take $1,000 out of your IRA then you’ll pay $250 in taxes.  The concept is kind of like:  take a tax deduction now/pay taxes later.  Here’s where it’s tricky…if you take the $1,000 out before you are 59 1/2, not only will you pay the $250 in taxes, but you’ll also pay a 10% penalty making the total tax you pay $350.  There are exceptions to the penalty if you use the money to buy a house or pay tuition.  You will pay the tax no matter what, but sometimes you can escape the penalty.
With the traditional IRA you are playing a gambling game.  You’re betting that your taxes are higher now and will be lower when you retire.  That’s a good bet for many people.  So the traditional IRA is a good thing.
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When you take money out of your Roth IRA, the money you take out is not taxable.  So, if you take out $1,000 from your Roth and you’re in the 25% tax bracket, you will pay zero tax on that $1,000.  If you take the $1,000 out before you turn 59 1/2, you may pay a 10% penalty on the earnings but not on the whole $1000.  Roth IRA means tax-free income later.
I really like the Roth IRA for a couple of reasons:
  1. 1.  It’s especially good for young people.  The Roth is a great savings tool that can be used for buying a home and paying college tuition.  If you invest in a Roth when you’re in the 15% tax bracket but wind up taking the money out when you’re in the 25% tax bracket:  zowie!  You win!  It’s like a little tax bonus.
  2. 2.  Even if you’re more mature and already in the 25%  tax bracket or higher, I still like the Roth.  When you’re retired and receiving social security payments, your social security isn’t taxable until you cross a certain income threshhold.  Once you cross that line, your social security becomes taxable and it’s like you’re paying double taxes.  For example:  let’s say your pension and social security put you right at the line where if you make any more money your social security would be taxable.  Once you cross that line you’ll pay tax on your social security income.  If you take money out of your traditional IRA, let’s use the $1,000 example again, and you’re in the 15% tax bracket, you won’t pay 15%–you’ll pay even more because now your social security will be taxed too.  It’s not exactly double, it’s more like one and  a half times more.  (Kind of a funky equation.)  Bottom line:  once you start receiving social security payments, extra income is actually taxed at an even higher rate than your real tax rate because they start taxing your social security.    Ouch!  Ask any senior citizen who’s been hit with this.  It hurts.
  3. Now  if your retirement income is so far over the threshold that you don’t need to worry about additional tax (because you’ve maxed out your taxable social security), or if it’s nowhere near the threshhold, then it’s not really an issue for you.  But for many seniors, extra taxable income can be a big problem for them.  The Roth IRA can be a real lifesaver when you’re older.
If it’s not completely obvious yet, I’m a big Roth fan.  That said, if you need a tax deduction now, then traditional IRA is the way to go.  For example:  one  year, I needed to lower my personal income by $310 to claim a $2000 tax credit.  That’s a no brainer, of course I spent $310 on a traditional IRA to save $2,000.  I put the rest of my retirement money into a Roth.  You can do stuff like that when and if you need to.
There’s so much to know about IRAs and it can be really confusing.  This little post is just the tip of the iceberg.  For detailed information about IRAs, the IRS has a book called Publication 590.  Here’s a link to it:  http://www.irs.gov/pub/irs-pdf/p590.pdf
Okay, I confess, that publication looks a little intimidating.  It’s 110 pages long.  But if you look at page one, the chapters and sections are set up based upon the questions people ask.  Look for your question and it will tell you the right page to find your answer.  It’s not so scary when you know that in advance.